What is owner financing? How does it work?
Owner financing is one of the many non-traditional ways to become a homeowner: a buyer finances through the current homeowner rather than a bank. It's a similar idea to rent-to-own, but a bit different.
Although not commonly used for real estate transactions involving primary residences, owner financing presents a potential alternative to the traditional lending model. This approach comes with plenty of risks, however, not to mention headaches and complications. Homebuyers should think long and hard before rejecting a conventional mortgage in favor of owner financing.
What is owner financing?
As the name implies, owner financing — also called “seller financing” at times — is a payment method in which the buyer takes out a loan from the original homeowner. In essence, the seller takes on the role of the bank or mortgage lender in the real estate transaction. So, rather than finance your purchase with a conventional mortgage, you would finance the purchase through the seller.
How does owner financing work?
To some extent, owner financing fundamentally functions the same way as a regular mortgage — just with the seller acting as the lender.
- Usually, the buyer will still make a down payment and finance the rest of the purchase with interest.
- The buyer and seller will set an amortization schedule and payment plan that needs to be followed.
- In most cases, you’ll still make mortgage payments each month, but they’ll go directly to the seller instead of a lender.
- A promissory note and owner financing contract will outline all of these arrangements in detail. That way, each party knows exactly what their responsibilities are and what specific terms of the loan need to be met before the property can change hands.
When would someone buy property with owner financing?
Some people may view owner financing as a simplified version of the often-complicated mortgage process. Other folks, meanwhile, may cast an understandably wary eye at this alternative. Why would someone ever choose to circumvent mortgage lenders completely given the potential headaches that owner financing presents?
In many cases, buyers turn to owner financing because they can’t qualify for a traditional mortgage. If you need a $400,000 home loan to buy a house, but lenders will only approve you for $300,000, you’re going to be out of luck. A private seller may have a higher threshold for risk or they may not fully appreciate the amount of risk they’re taking on through this kind of transaction.
Just because a conventional 30-year fixed rate mortgage seems out of reach doesn’t mean you have to resort to fringe payment options, though. There are plenty of ways to get more flexible lending terms, eligibility requirements and down payment options. FHA loans, VA loans and down payment assistance programs are all viable alternatives that carry far less risk than owner financing.
It’s worth noting that the vast majority of owner financing deals involve real estate investments. For someone whose capital is tied up in multiple properties and who doesn’t have a lot of liquid assets to their name, this payment approach could make sense. From the seller perspective, owner financing on a rental property could be appealing due to the prospect of raking in recurring revenue each month.
Owner financing is much less common when buying a primary residence, though. And even when it does happen, it usually involves two parties who know each other extremely well, like close friends or family members. Sellers take on a lot of risk by agreeing to owner financing, so having a strong, established relationship with the buyer can help ease any potential concerns.
What are the benefits of owner financing?
Buying property with owner financing means you don’t get the protection or support that a mortgage lender provides. That being said, there are some potential benefits — potential being the key word here — that come with this approach:
- Gain more negotiating power
- Customize your loan agreement
- Avoid lengthy underwriting process
- Purchase property with weak loan application credentials
Owner financing can give a buyer more negotiating power
Some aspects of the homebuying process are negotiable — purchase price or closing costs, for instance. But when it comes to your amortization schedule, down payment and interest rate, your lender’s going to hold all the cards. It never hurts to ask for a lower interest rate or more favorable financing terms, of course, but lenders will never exceed their risk threshold to satisfy a potential borrower.
Private sellers, on the other hand, won’t have such carefully structured frameworks for extending a home loan. You may be able to negotiate lower down payments and interest rates, possibly even at the seller’s expense.
Customize your loan agreement
When negotiating the terms of your home loan, you could also create a customized amortization and payment schedule. While most conventional home loans require monthly mortgage payments over the span of 15 or 30 years, an owner financing contract can schedule payments at any cadence. You could make a payment every two months for five years, for instance. Although lenders have more financing options than most people realize, including 10-year mortgages and interest-only mortgages, you could theoretically draw up a loan contract any way you like with owner financing.
Avoid lengthy underwriting process
There’s no denying that the mortgage process can be long and complicated, but it’s for a good reason. Lenders need to thoroughly vet borrowers to ensure the loan will be paid back in full. The last thing anyone wants is for you to overextend your finances and wind up defaulting on your mortgage. But that due diligence takes time and requires a detailed review of your financial situation.
Few — if any — private sellers will have the resources or know-how to check credit reports, review multiple years of W-2 forms or look for red flags in bank statements. The buyer’s word alone could be good enough for them. In some cases, buyers can close on a owner-financed property in very short order, largely because underwriting isn’t involved at all.
Owner financing drawbacks
All of those benefits may sound appealing, but there’s a reason owner financing is so uncommon — several reasons, actually. These drawbacks should give you pause if you’re considering a workaround to the traditional lending model:
- Buyers aren’t always protected by contingencies
- Sellers may not follow consumer protection laws
- Sellers may reject your offer
- Balloon payments may come back to haunt you
Buyers aren’t always protected by contingencies
Like we said before, mortgage lenders do their due diligence when approving a home loan. They’re not just looking into the borrower, though. Part of the underwriting process includes a review of the property’s history and market value.
Appraisal inspections check that the loan amount doesn’t exceed the value of the property. And while lenders conduct appraisals to avoid extending a mortgage that’s worth more than the house, appraisal contingencies also protect you as a borrower. You don’t have to worry that you’re paying far more than a home is worth, because your lender would never approve that transaction.
Meanwhile, mortgage lenders work with borrowers to run property title searches and obtain title insurance for every home loan. If there are title defects and ownership claims that raise major concerns, these safeguards will help work them out or give the buyer an escape hatch to back out of the deal.
That’s not always the case with owner financing. As a buyer, you might not find out about title defects until it’s too late, and you could be on the hook paying legal costs and other expenses sorting those issues out. That’s assuming those problems can be addressed at all.
If you do go the owner financing route, it is essential that you account for these items as best as you can. Make the sale agreement subject to an appraisal and home inspection, just like any traditional real estate contract. Then order your own inspection and appraisal. Insist that the seller provide a title insurance policy before going forward with the sale. Without the protection of a qualified lender, you’ll have to fend for yourself.
Sellers may not follow consumer protection laws
Lenders must adhere to various consumer protection laws, especially when it comes to late charges and defaults. A private seller is under no such obligations. Now, that doesn’t necessarily mean the seller will take advantage of the situation and charge excessive late fees or other penalties. But there’s nothing preventing them from drawing up a sale agreement that explicitly allows them to levy fees that exceed industry standards, either.
Sellers may reject your offer
Owner financing presents a lot of potential headaches for sellers. It requires a more hands-on role that continues through the entire life of the loan. Many people just want to sell their house and move on to their next home. Having to worry about the buyer continuing to make scheduled payments and keep up with the amortization schedule could be too much for your average Joe to deal with.
The potential risk of default could also raise red flags. It’s reasonable for the seller to question the buyer’s ability to pay down debt if mortgage lenders wouldn’t approve the same loan. Given these concerns, it can be difficult to find a seller willing to roll the dice on owner financing.
Balloon payments may come back to haunt you
At one point in time, balloon payments were pretty common in the lending industry. But that’s long in the past. Nowadays, many consider these payment structures to be examples of predatory lending practices. The basic idea with balloon payments is that the borrower pays the bulk of the loan all at once at the end of the amortization schedule. You may find yourself on the hook for a large lump sum payment you simply can’t afford to make. If that’s the case, your options are to either refinance your mortgage or take out a new mortgage to cover the remainder of the original loan amount.
It’s easy for buyers to get lulled into a sense of financial complacency while neglecting to save up enough money to cover that balloon payment. And if you don’t get the necessary funds in time — or are unable to get approved for a new mortgage or refinance — you could be at a high risk of defaulting on your loan. Because of these concerns, mortgage lenders rarely build balloon payments into their loan contracts, but a private seller might.
In conclusion
Owner financing is a possible alternative to traditional mortgages, but homebuyers should approach with caution. Without the consumer protection laws that mortgage lenders must follow, buyers could see owner financing backfiring on them.
Most transactions that use owner financing involve real estate investments, such as buying an apartment complex to earn passive income. It’s far less common for someone looking to buy a home to take this approach.
Conventional mortgages are conventional for a reason: They’re a reliable source of financing. Even people who may struggle to qualify for that kind of loan still have plenty of other options to consider, from government-insured loans like FHA mortgages to down payment assistance programs through a housing agency or not-for-profit. Talk to a qualified loan officer to understand the full scope of your loan options so you can make an informed decision that suits your financial situation.